Affordable Housing Institute : US

Whose fault is the implosion following our hyperinflated pricing bubble? 

 

I couldn’t make things ADD up …

 

Not subprime lending.  Not CRA.  Not US profligacy.  Maybe it’s starvation for yield, or maybe it’s a kind of currency smuggling by manipulating the exchange rate by China, as speculated in a deliberately provocative Washington Post Op Ed, What OPEC Teaches China, by Sebastian Mallaby.

 

Pointing the finger in print

 

At his confirmation hearings last week [January 25, 2009 –Ed.], Tim Geithner branded China a currency manipulator.

 

One of us has tentacles … the other is a manipulator

 

Geithner is correct that China manipulates its currency. What’s more, this manipulation is arguably the most important cause of the financial crisis.

 

As we examine Mallaby’s exegesis of Geithner’s accusation, we should see it as merely a particular example of the much larger Law of Economic Pressure, the evil twin of the Law of Economic Gravity (uneconomic endeavors will not survive):

 

 

One of us is the Law of Economic Gravity …

The other’s the Law of Economic Pressure

 

           

 

For the last decade or more, capital has been global, and as a result, money-investing pressure from elsewhere found its expression in the US.  The result was cheap credit:

 

Being a commodity, money has a demand – people who go to the money store needing it for investment – and a supply, people who come to the money store looking for yield. 

 

 

When the supply of money (that is, people who want to invest) exceeds its demand (quality investments to make), two things happen:

 

* Yields go down because money becomes cheaper.

* Investments increase as new products are invented and come into the marketplace.

 

If the world has more wine drinkers than vineyards, marginal soils are planted and plenty of plonk is sold and drunk.

 

Because of the pricing equilibrium, cheap credit drove up prices of assets like homes. 

 

All that would be challenging enough if the game were entirely fair.  What if it was rigged?

 

Don’t go in there, you’re not Mature enough

 

Starting around the middle of this decade, China’s cheap currency led it to run a massive trade surplus. The earnings from that surplus poured into the United States. The result was the mortgage bubble.

 

Here’s a corollary of the law of Economic Pressure – if you’re trying to keep money in a country where it wants to flee, currency restrictions and aid flows are like filling a sieve.  If the Chinese really thought that by manipulating their currency they could gain a huge financial advantage, all the world’s trade restrictions wouldn’t have stopped it. 

 

China’s leaders protest that they are being unfairly scapegoated. Yet while there are rival accounts of the origins of the crisis, neither has the explanatory force of the blame-China narrative.

 

The Law of Economic Pressure is the basis behind every smuggling operation ever invented.  From Goldfinger’s transport of gold into India (as airplane seats, from Geneva where it arrived as the old Rolls Royce Silver Ghost) to the coyotes’ transport of Mexicans into America, smuggling is always pursued because it is, in the words of a suave villain from Harper, “dizzz-gust-in’ly lucrative.” 

 

Waiting for a coyote, Guadalajara

 

This applies not just to commodities, but also to money.

 

The first rival account is that the crisis reflected failings of U.S. financial regulation. Such failings exist, but most have been around for years. The mortgage bubble reached its craziest extremes in 2005-07, when China was flooding the world with cheap capital.

 

This is the global economy before Chinese capital exports

 

This is the global economy after Chinese capital exports

 

Because money is fungible – think of it as financially gaseous – any increase in pressure, coupled with any leak in security, equals a powerful jet of flow. 

 

Moreover, regulatory failings exist not just at one regulator but many.

 

We saw this; the phenomenon is global, but confined to a single nation.  As I listed before:

 

So far we’ve seen that almost everybody is wrong about what the financial crisis is …

 

1. Not an asset bubble … a systematic under-pricing of risk.

2. Not caused by subprime lending … although that was the miner’s canary.

3. Not principally about the GSEs … because other financial institutions are in much worse shape

4. Not just about housing … although that is the biggest asset class

5. Not specific to the US … although as the world’s biggest and probably fastest economy, we caught cold first.

 

… and who’s to blame …

 

America – putting the unum in everyone’s pluribus

 

6. It’s not proof of ‘under-regulation’ … provided we have a reasonable definition of ‘regulation’. 

7. It’s not the [US] government’s fault … or if it is, we’re e pluribus unum.

8. There’s no single culprit … plenty of blame to go around, step right up and claim your share.

9. It’s not really rational … but as John Maynard Keynes said, “The market can stay irrational longer than you can stay solvent.”

 

What I like about the Mallaby/ Geithner hypothesis is its scale. 

 

The Securities and Exchange Commission failed to check risks at broker-dealers such as Bear Stearns. State insurance regulators failed to prevent the collapse of AIG. The Federal Reserve failed to see that banks were pouring capital into toxic securities that they then held off their balance sheets.

 

It’s possible, of course, that each of these was a systemic failure, a Law of the Unobservant Herd or a case of global otherguy due diligence – the British, say, assuming that since the Americans were innovating these vehicles, they must be safe, and the Americans concluding that they were safe because even the stodgy old Bank of England had blessed them.

 

Perfectly safe, I assure you

 

European regulators were no better, even though they had adopted a supposedly more up-to-date set of capital standards.

 

Since the entire world got drunk on risk-taking, we need an explanation with a global scale – which means we need a capital-markets or money explanation, because only money can flow so swiftly across borders.

 

The lesson: Faced with a deluge of cheap money, no regulatory regime can be expected to prevent bubbles.

 

As we saw in Old New Orleans, we build physical dams to hold back the ocean, and yet the ocean can surge to levels that overwhelm even Corps of Engineers safety standards. 

 

Something similar happens to financial dams; we can block capital when it comes in individual wallets or even individual company transactions, but let the flows be those of sovereign wealth, let them be placed financially uphill by skewing the currency, and millions of individual transactions will all flow that way just like billions of water droplets.

 

The second rival account of the crisis accepts that its origins lie less in regulatory failings than in economic pressures.

 

Sir, the regulatory systems didn’t work quite as planned

 

Markets move faster than government; people are economically rational given the choices before them.  Tilt the currency and the people follow the money.

 

But it blames the bubble on two mistakes at home rather than on the glut of capital from China.

 

[1] Americans should have controlled the urge to splurge, the thinking goes, and borrowed less Chinese money.

 

The problem is this: when anything is cheap, people consume more of it.  Housing demand, like all forms of demand, is elastic.  When housing is cheap, people buy bigger houses, rent larger flats, reduce their household size (roommates become singles, stay-at-homes move out).  You can’t blame people for acting in what they think is their self-interest.

 

Controlling expenditure and managing the economy isn’t a job for consumers but for central bankers; if people weren’t to blame, can we blame the central bankers?

 

We won’t feel happy until we blame somebody

 

[Continued tomorrow in Part 2.]

 

Send post as PDF to